2. Outlook and Policy Challenges for Latin America and the Caribbean

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1 . Outlook and Policy Challenges for Latin America and the Caribbean Economic activity in Latin America and the Caribbean (LAC) is undergoing a protracted slowdown, in tandem with weaker underlying fundamentals. Growth is projected to decline again in 15, turning negative before rebounding modestly in 16. Externally, renewed weakness in commodity prices has further deteriorated the region s terms of trade, reflected in widening current account deficits, exchange rate depreciation, and weakening investment. Financial market strains have also risen to varying degrees, with retreating capital flows placing additional downward pressure on currencies, thus testing the credibility of existing policy frameworks. Domestically, headwinds to growth owing to country-specific factors are also mounting. Policy responses depend on country circumstances, including the depth of the downturn and degree of domestic rigidities. Some countries have already embarked on policy adjustment, but others will need to tighten policies further to address fiscal or external sustainability concerns. Net commodity importers can use the breathing room from lower commodity prices to deepen fiscal adjustment. Exchange rate flexibility remains instrumental for external adjustment, while structural reforms are crucial to address low trend growth. Protracted Slowdown Economic activity in Latin America and the Caribbean (LAC) has been slowing steadily since 1 (Figure.1). After several years of high commodity prices and strong regional growth, a period commonly referred to as the commodity super-cycle, commodity prices have been decreasing since 11, in tandem with a deceleration in Chinese economic activity, weakening the region s Note: Prepared by Marcello Estevão and Nicolas Magud with Ravi Balakrishnan, Carlos Caceres, Geoffrey Keim, Bogdan Lissovolik, Alla Myrvoda, Koffie Nassar, Julien Reynaud, and Marika Santoro and contributions from Ahmed El Ashram, Sebastian Acevedo, and Arnold McIntyre. Geneviève Lindow and Steve Brito provided excellent research assistance, with contributions from Anayochukwu Osueke. terms of trade. Moreover, this external shock is likely to be persistent. In addition, financial market pressures have risen recently to differing degrees across economies depending on their fundamentals. Concomitantly, important domestic vulnerabilities or constraints have further weighed on growth in key economies. Against this backdrop, a sharp deceleration is projected in economic activity for LAC in 15 implying a slight real GDP contraction ( ¼ percent), followed by a modest rebound in 16. The deceleration reflects underlying weaknesses in both aggregate demand and supply, in the context of a less benign external environment. This said, the magnitude and duration of the slowdown is not unusual from a historical perspective (Box.1). Obviously, this broad outlook does not apply to every single country in LAC, with net-commodity importers of Central America and the Caribbean benefitting from improved terms of trade and a recovering U.S. economy. Terms-of-Trade Shocks Lower global prices for energy, metals, and agricultural goods have been a key factor behind the slowdown. The steady reduction in the region s commodity terms of trade over the last several years has lowered national incomes, reducing private investment 1 and consumption. For example, the drop in commodity terms of trade resulted in more than percentage points of GDP loss for Venezuela, close to 1 percent for Ecuador, about 7 percent for Bolivia and Chile, 5½ percent for Colombia, and about percent for Peru (Figure.). The terms-of-trade shocks to Argentina, Brazil, and Mexico have been weaker; around percent of GDP or less. 1 Regional Economic Outlook: Western Hemisphere, April 15, Chapter. 15

2 REGIONAL ECONOMIC OUTLOOK: WESTERN HEMISPHERE Figure.1 Economic Activity in Latin America and the Caribbean Commodity prices have been deteriorating and weakening the region s terms of trade, resulting in decelerating activity and reduced medium-term growth projections. 1. Commodity Prices (Index: 1:Q1 = 1). LAC: Currency and Terms of Trade (Index: 5 = 1) Real effective exchange rate¹ Terms-of-trade index² Petroleum Copper Iron ore Soybeans 1:Q1 11:Q1 1:Q1 13:Q1 1:Q1 15:Q1 16:Q Selected Latin American Countries: Contributions to Real GDP Growth 3 (Year-over-year percent change) 1 8 Net exports Consumption Inventories Real GDP Investment :Q1. LAC: Projections for End-of-Horizon Real GDP Growth by WEO Vintage, 15 (Percent) Sources: Haver Analytics; IMF, Primary Commodity Price System database, IMF, World Economic Outlook database; national authorities; and IMF staff calculations and projections. 1 Purchasing power parity GDP-weighted average of Argentina, Bolivia, Brazil, Chile, Colombia, Costa Rica, Ecuador, El Salvador, Guatemala, Honduras, Mexico, Nicaragua, Panama, Paraguay, Peru, Uruguay, and Venezuela. Data for 15 are a projection. Purchasing power parity GDP-weighted statistics; sample includes all 3 LAC countries for which IMF staff estimates terms of trade. 3 Seasonally adjusted. Purchasing power parity GDP-weighted averages of Argentina, Brazil, Chile, Colombia, Costa Rica, Mexico, Paraguay, Peru, and Uruguay. Inventories include statistical discrepancies. See Annex.1 for details on Argentina s GDP Fall Fall Fall 3 Fall Fall 5 Fall 6 Fall 7 Fall 8 Fall 9 Fall 1 Fall 11 Fall 1 Fall 13 Fall 1 Fall 15 Fall. WEO vintage.8 On the supply side, the dampened outlook for commodity prices has triggered a reevaluation of the region s growth potential, including because See World Economic Outlook, October 15, Chapter, which finds that annual output growth for commodity exporters, and to some extent medium-term growth, tend to fall during downswings in commodity prices. of the impact of decelerating investment on capital accumulation (Figure.1). For most economies in the region, current account and trade deficits widened, while currencies have weakened noticeably. The timing and impact of the shock have varied at the country level, largely because many commodity prices have been weakening since 11 (for example, metals), while 16

3 . OUTLOOK AND POLICY CHALLENGES FOR LATIN AMERICA AND THE CARIBBEAN Figure. Peak-to-Trough Change of Commodity Terms of Trade (Percentage points of GDP) Metals Energy Food Advanced Figure.3 Current Account Adjustments Current account adjustment occurring at difference pace across countries depending on the type of main commodity exported, and the size and timing of negative price shocks. 1. LA5: Current Account (Percent of GDP) Brazil Chile Colombia Mexico Peru New Zealand (Jun 15) Mexico (Jan 15) Brazil (Aug 15) Argentina (Oct 1) Canada (Jan 15 ) Peru (Jul 13) Australia (Apr 15 ) Colombia (Jan 15) Bolivia (Apr 15) Chile (Oct 11) Ecuador (Jan 15) Venezuela (Jan 15, right scale) Sources: Gruss 1; and IMF staff calculations. Note: Through period of current commodity terms of trade cycle in parentheses for each country. Excludes precious metals, except in Bolivia, Colombia, and Peru. 6 8 Mar-11 Jun-11 Sept-11 Dec-11 Mar-1 Jun-1 Sept-1 Dec-1 Mar-13 Jun-13 Sept-13 Dec-13 Mar-1 Jun-1 Sept-1 Dec-1 Mar-15 Jun-15 others started to decline more recently (such as oil, since mid-1). In turn, external adjustments to weaker commodity terms of trade are at different stages (Figure.3). Chile, being a major exporter of copper, for example, has already undergone significant adjustment in its external current account, with a deficit that is now closed. In contrast, Colombia is still in the midst of adjusting to more recent price declines in oil, its main export.. Other Commodity Exporters: Current Account (Percent of GDP) 6 Mar-11 Jun-11 Argentina Ecuador Venezuela Sept-11 Dec-11 Mar-1 Jun-1 Sept-1 Dec-1 Mar-13 Jun-13 Sept-13 Dec-13 Mar-1 Jun-1 Sept-1 Dec-1 Mar-15 Jun-15 Adjustment to pressures in the external account has been facilitated by currency movements. Indeed, exchange rate developments have partly reflected weakening terms of trade and the timing of shocks to country-specific commodity prices, with larger depreciations for countries with greater exchange rate flexibility. In turn, more flexibility facilitated a faster response of exports and imports to softer terms of trade. Some (for example, Chile) that have allowed their exchange rates to respond flexibly to the external shock have seen a significant narrowing of previously large external deficits. Adjustment has been slow in countries where exchange rate depreciation has proceeded at a more gradual pace Sources: Haver Analytics, and IMF staff calculations. and supply-side constraints have temporarily dented exports (for example, Peru). In contrast, countries with dollarized economies (for example, Ecuador) or pegs to the U.S. dollar (for example, Bolivia) have had less room to maneuver in these countries, current accounts have widened making them more vulnerable. Net commodity importers in the Caribbean (which have pegs to the U.S. dollar, see Box.) and dollarized economies of Central America have benefitted from lower oil prices, although they continue to post large current account deficits. 17

4 REGIONAL ECONOMIC OUTLOOK: WESTERN HEMISPHERE Domestic Headwinds Although the main shock has been external, domestic factors have also played an important role in some countries. For instance, the region s largest economy, Brazil (for which the terms-of-trade shock has been relatively small), has relied too much on demand-bolstering measures in the past and finds itself with limited policy buffers. Moreover, the country is in a tough spot with a case of corruption and a political crisis adversely affecting confidence, thus playing a key role in the deepening recession. The weakening of the currency more recently, however, is expected to provide some relief to tradable sectors of the economy. Some other countries are stuck in a rut of distortionary interventions and/or weak macroeconomic frameworks and policies. Venezuela is an extreme case, where microeconomic distortions combined with unsustainable macroeconomic policies have led to large imbalances, including very high inflation (indeed, the highest inflation rate in the world in 1), a deep contraction in activity (the third largest in the world in 1), and a widening fiscal deficit (the second largest in the world in 1). In Argentina, inflation remains high owing to the monetization of the fiscal deficit. Lack of market access is hurting activity and distortive macroeconomic and microeconomic policies are affecting the country s fundamentals. As a result, inflation in Argentina was the fifth highest in the world in 1. Financial Market Pressures Financial conditions, meanwhile, have started to tighten in reaction to a changing external environment, although with differentiation depending on domestic realities. The worsening growth outlook for LAC economies, in general, and the strengthening U.S. recovery with its implications for the Federal Reserve s interest rate tightening (see Chapter 1) have moderated net capital flows to the region, exerting further exchange rate depreciation pressures (Figure.). Going beyond terms-of-trade changes, currency depreciation has varied within the region, depending on macroeconomic frameworks and country-specific developments, including political stability and past policy decisions. Financial market pressures, more broadly speaking, have been differentiated given underlying fundamentals. Equity prices have come down (Figure.5), while corporate spreads have risen, although currency depreciations so far do not seem to have caused noticeable balance-sheet strains from possible mismatches between corporate dollar Figure. Capital Flows (Three-month moving sum, percent of initial stock) Some capital flows turned negative recently. 1. Bonds Weekly Data 6 Brazil Mexico Chile Peru Colombia 6 Aug-1 Nov-1 Feb-15 May-15 Aug-15. Equities Weekly Data Brazil Mexico Chile Peru Colombia 6 Aug-1 Nov-1 Feb-15 May-15 Aug-15 Sources: Haver Analytics, based on EPFR Global; and IMF staff calculations. 18

5 . OUTLOOK AND POLICY CHALLENGES FOR LATIN AMERICA AND THE CARIBBEAN liabilities and assets. 3 Less financially integrated economies remained relatively shielded from volatility in financial asset prices but imbalances have surfaced in the form of rapidly deteriorating fiscal and external balances (for example, Bolivia and Paraguay) and a scarcity of goods in Venezuela. Overall, changes in financial conditions in large swaths of the region have reinforced weaker economic fundamentals. Market pressures have further hurt consumer and business confidence and, in turn, amplified the downward adjustment in activity. These underlying forces intensified more recently as markets downgraded the outlook for Chinese economic growth and financial stability. Besides being a key source of demand for commodities, China is also an important trade partner for many countries in the region, including Brazil, Chile, Peru, Uruguay, and Venezuela. The volatility in financial conditions since August has added to the steadily worsening economic outlook for the region (Figure.6). On the positive side, the economic recovery in the United States will provide some support to LAC s economic growth. That applies in particular to countries with strong links to the U.S. economy, including through trade (Mexico and Central America), remittances (Central America) and tourism (Caribbean). Downside Risks Dominate Risks around the baseline are tilted to the downside. If the U.S. economic recovery falters, the economies of Mexico (the second largest in LAC), Central America, and the Caribbean would feel the largest 3 Chapter 3 of the October 15 Global Financial Stability Report finds that corporate leverage has edged up in Chile, Brazil, Mexico, and Peru. The chapter shows that global drivers have played a significant role in explaining the growth in emerging markets leverage and corporate spreads, suggesting that, in general, those countries must be prepared for a tightening in financial conditions as the U.S. Federal Reserve starts raising interest rates. This is particularly applicable to Latin America, which seems especially sensitive to financial conditions in the United States (Chapter 3). 19

6 REGIONAL ECONOMIC OUTLOOK: WESTERN HEMISPHERE Figure.6 LAC Growth The regional growth deceleration started in 1 is projected to continue in LAC: Real GDP Growth 1 (Percent) Projections NCE ; 35 5 : Financially integrated economies (LA6) 3. Other commodity exporters 3 6. CAPDR 3. Caribbean Tourism-dependent Commodity exporters 3.8 Ogoqtcpfwo"kvgou< Brazil.7 Mexico 1.. LAC: Growth Momentum, 1 15 Difference in growth rates. 15 versus 1 Marked slowdown: <= 1% Moderate slowdown: > 1% and <=.% Stable growth: >.% and <.% Growth pick-up: >=.% Sources: IMF, World Economic Outlook database; and IMF staff calculations and projections. Note: For country group information see page For definitions of the other country groups and details on the aggregation method, see Table.1. Purchasing power parity GDP-weighted average. 3 Simple average. Previous U.S. monetary tightening cycles have been typically associated with a declining term premium on U.S. long-term yields. However, the term premium is currently well below historical averages (Chapter 1). That could reverse if markets perceive policy risks going forward. Stronger wage growth or another sign of growing inflationary pressures in the United States could also raise the term premium on top of a steeper path for expected changes in short-term rates. A sharper rise in longer-term bond yields in the United States associated with a larger term premium would trigger tighter financial conditions and lower economic growth in Latin America (Chapter 3). China s recent stock market volatility and changes in currency management illustrate the potential for shocks from Asia. A harder-than-expected landing of the Chinese economy would have deleterious effects on external demand for LAC s exports and commodity prices more broadly. The latter would affect South America negatively but represent a boon to net commodity importers in the region (mainly Central American countries and most of the Caribbean). Moreover, this highlights the need for diversifying away from commodity dependence. Deeper integration into global value chains could raise diversification in LAC economies. But, we find that the direct trade impact on LAC of more integration into global value chains would likely be small (Chapter ). The potential for financial disturbances emanating from Europe is still alive despite the positive developments in the Greek negotiations. However, direct spillovers to asset prices in LAC would probably be minor, as seen during recent episodes, partly owing to the region s limited financial integration (Box.3). pain. Of course, an upside to the U.S. recovery would be good for the world economy and there is some evidence that capital flows to LAC could grow if U.S. Federal Reserve policy rates were to rise owing to better growth dynamics, as long as the term premium embedded in long-term U.S. treasuries does not rise (Chapter 3). More importantly, the expected lift-off of policy rates in the United States poses risks to the region. Financially Integrated Economies Developments and Outlook Economic activity among Latin America s financially integrated economies (LA6: Brazil, Chile, Colombia, Mexico, Peru, and Uruguay) has diverged, as external and domestic factors weigh differently in each country (Figure.7).

7 . OUTLOOK AND POLICY CHALLENGES FOR LATIN AMERICA AND THE CARIBBEAN 1

8 REGIONAL ECONOMIC OUTLOOK: WESTERN HEMISPHERE After stalling in 1, the Brazilian economy is projected to contract noticeably by 3 percent in 15 and 1 percent in 16. While external factors such as deteriorating commodity prices explain some of the contraction in activity, domestic factors are the biggest drag. Brazil entered mid-1 with large macroeconomic imbalances stemming from a diagnosis that the economic slowdown since 1 was caused by lack of sufficient aggregate demand. With inflation well above the central bank target, public policies appropriately shifted to avoid a more severe economic crisis toward a tighter monetary stance and a fiscal adjustment to contain inflationary pressures and stabilize the trajectory of public debt. At the same time, a serious political crisis has been triggered by a wide-ranging investigation of corruption involving Brazil s major oil company, Petrobras, its private sector contractors, and politicians; allegations of campaign finance irregularities during the 1 presidential elections; and a review by the Federal Court of Accounts questioning the 1 fiscal accounts. The interaction of the economic and political crisis has fueled uncertainty and driven consumer and business confidence to historical lows, further undermining current and prospective economic activity. The economic slowdown has depressed fiscal revenues well below the authorities initial expectations and, together with lack of congressional support for further spending cuts, led to a marked downward revision of fiscal targets for This has raised market concerns about the sustainability of public debt, and triggered a sovereign downgrade to junk status by a debt rating agency this September. Largely reflecting these developments, yields on government debt have risen steeply since July. Specifically, on September 9 Standard and Poor s moved Brazil s sovereign rating below investment grade. A number of banks and nonfinancial corporations credit rating was downgraded as well, in accordance with Standard and Poor s policies for rating other issuers in relation to the sovereign. So far, Fitch and Moody s have kept Brazil s sovereign investment grade credit rating. In Mexico, the economy is projected to expand by ¼ percent in 15 and ¾ percent in 16 more slowly than previously anticipated. The more gradual recovery is attributed largely to a further decline in oil production and a weaker-thanexpected recovery in construction activity. Fiscal consolidation is projected to have exerted only a modest drag on growth. Looking ahead, a projected rebound in industrial activity in the United States should boost manufacturing output and overall growth in Mexico. On the negative side, low oil prices have forced the government to announce a restrictive fiscal budget for 16 and underscore recent downward revisions in growth potential. The implementation of structural reforms is expected to work in the opposite direction and boost economic activity in the medium term through higher private investment and increased productivity. In Chile, domestic factors have added to the drag on activity emanating from falling commodity prices. Private domestic demand is expected to remain subdued in 15, with private investment affected by the large decline in business confidence reflecting both low copper prices (which fell by about percent in the three months between May and August 15) and the short-term costs from the structural reform agenda. Consumer confidence also weakened in 15, on the back of slower growth in private sector employment and wages. Chile s real GDP growth is expected to pick up modestly in 15 to ¼ percent, mainly reflecting the large fiscal stimulus this year (in particular through greater capital spending). Growth for 16 is projected at ½ percent, over ½ percentage point less than that projected in April, on account of weaker copper prices. The recent depreciation of the peso (15 percent since May) is expected to slow the return of inflation to within the central bank s target range, but medium-term inflation expectations remain anchored around the central bank s 3 percent target. Peru s growth slowed sharply last year as a result of a drop in private investment as well as subnational public investment and temporary supply disruptions in fishing, mining, and agriculture. As some of the shocks lingered into 15, and were

9 . OUTLOOK AND POLICY CHALLENGES FOR LATIN AMERICA AND THE CARIBBEAN compounded by the renewed slide in metal prices, Peru s economy is projected to grow this year at a similar pace as in 1 (about ½ percent). Growth is expected to pick up to about 3¼ percent in 16, supported by a rebound in mining production, although there is considerable uncertainty, including from a possibly stronger-than-expected negative impact from the El Niño weather phenomenon. Whereas Chile and Peru have been adjusting to lower metal prices since 13, the Colombian economy has been hit by the more recent sharp decline in oil prices. Real GDP growth is projected at ½ percent in 15, down from.6 percent in 1, as the sizable worsening of its terms of trade since mid 1 has hurt domestic income, business confidence, and private investment. As oil prices stabilize in 15 and the U.S. economy continues to recover, growth is projected to rebound modestly in 16. However, lower oil prices increase fiscal challenges owing to reduced revenues. Negative spillovers from weak economic activity in Argentina and Brazil are expected to weigh on growth in Uruguay, projected at ½ percent in 15 about 1 percent lower than in 1 slowing to ¼ percent in 16. Notwithstanding the deceleration in economic activity so far, inflation remains stubbornly above the central bank s target band. Labor markets are weakening (with the rapid rise in the unemployment rate in Brazil in the past 1 months being particularly noteworthy) and real wages growth has slowed in most countries since end-1 (Figure.8). Despite growing labor market slack, other indicators, such as large external current account deficits and relatively high inflation, suggest little space for active demand support in LA6 economies, though. The current account deficits have been financed in great part by sizable foreign direct investment (FDI), although portfolio inflows have also contributed and foreign ownership of domestic assets increased in most countries (Figure.9). This entails some risks if international financing conditions were to change abruptly. The LA6 financial sector appears reasonably sound, with low levels of non-performing loans (NPLs). However, corporate and household debt has been increasing in most countries, requiring vigilance, especially as international interest rates are set to rise. 5 For instance, in Brazil, NPLs for at least 9 days remain at 3 percent system-wide; nevertheless, for non-earmarked loans, which represent about onehalf of bank loans, NPLs stood at.8 percent in July, their highest in 19 months. The ongoing recession and rising unemployment are expected to further affect loan performance in coming quarters. While banks soundness indicators remain strong, their profitability is likely to be affected by the overall state of the economy. Credit has been decelerating for several quarters now, and in real terms credit to the private sector stopped growing in July. Excess exchange rate volatility might pose additional risks to countries with larger exposure to foreign exchange credit (for example, Peru and Uruguay). In addition, a weaker currency could help boost exports noticeably in more diversified economies (for example, Brazil) but its effect could be more limited elsewhere, at least until investment can be directed to other tradable sectors. The negative income effect from lower commodity 5 Global Financial Stability Report, October 15, Chapter 3. 3

10 REGIONAL ECONOMIC OUTLOOK: WESTERN HEMISPHERE

11 . OUTLOOK AND POLICY CHALLENGES FOR LATIN AMERICA AND THE CARIBBEAN Figure.1 Monetary Policy, Inflation, and Capital Flows Inflation is on the rise, but inflation expectations remain well anchored. Though moderating, capital inflows have continued to finance LA6 s widening external current account deficits. High shares of non-resident holdings of domestic debt remain a risk. However, large stocks of international reserves and exchange rate flexibility provide some protection from external shocks. 1. LA5: Monetary Policy Rates 1. LA6: Gross Capital Inflows 3 (Percent) (Billions of U.S. dollars, -quarter moving average) 16 1 Latest monetary policy rate 17 inflation market expectations 1 Inflation target range Depreciation of exchange rate (right scale) Direct investment Portfolio investment Other investment Brazil Chile Colombia Mexico Peru Uruguay :Q 3. LA5: Nonresident Holdings of Domestic Debt (Percent of total) 5 3 End-1 Latest. LA6: Official Foreign Exchange Reserves, 1 (Percent of GDP) 3 Maximum access under the Flexible Credit Line Gross international reserves Cumulative net position in foreign exchange swaps and repos 1 percent of IMF's reserve adequacy metric 1 percent of short-term external debt Brazil Chile Colombia Mexico Peru Brazil Chile Colombia Mexico Peru Uruguay Sources: Bloomberg, L.P.; IMF, Balance of Payments Statistics Yearbook database; IMF, International Financial Statistics database; IMF, World Economic Outlook database; national authorities; and IMF staff calculations. Note: For region name abbreviations, see page 89. ¹Data come from national authorities, surveys, and market participants. ²National currency per U.S. dollar. Percentage change on the average of June 1 to the average of September 15. ³Excludes Peru. Methodology described in Assessing Reserve Adequacy, Specific Proposals, IMF (15). prices, and, thus, lower domestic purchasing power would counteract some of the positive exports effect from a currency depreciation. The Latin American experience suggests that the net benefits of a currency depreciation associated with lower commodity prices are indeed limited. 6 Inflation rates are either near or above the upper bound of the inflation target range in LA6 but markets expect that 17 inflation will fall within targeted ranges (Figure.1), with the exception of Uruguay, suggesting limited second-round effects from the currency depreciation so far. 6 Regional Economic Outlook: Western Hemisphere, April 15, Chapter. 5

12 REGIONAL ECONOMIC OUTLOOK: WESTERN HEMISPHERE Policy Priorities Persistently weaker commodity prices have changed the outlook for LA6 economies. Financial conditions are expected to tighten and currencies could soften further. Against this backdrop, policymakers need to continue to allow exchange rate flexibility aiming at facilitating external adjustment, while keeping an eye on inflation targets. The depreciation in regional currencies reflects a relative price shock and weaker underlying fundamentals and, thus, should be accommodated by the monetary authorities. Central banks should, however, remain attentive to possible secondround effects (for example, accelerating wage demands or unmooring of inflation expectations) and tighten the monetary stance if needed to preserve the credibility of their inflation target frameworks. So far, medium-term inflation expectations remain within the targeted ranges (Figure.9). Exchange rate flexibility comes with a risk, though, especially where the exposure to foreign exchange denominated-debt, in a context of increasing leverage, is relevant. While there are only a few indications of large corporate balance-sheet mismatches in LA6 countries to date, authorities in more dollarized economies (Peru and Uruguay) need to be especially attentive to excess exchange rate volatility. If needed, intervention in foreign exchange markets should be temporary and limited to smoothing short-term fluctuations in exchange rates, aimed at avoiding excessive volatility, possibly following a rulesbased, sterilized operation. While the current debt outlook is generally manageable in LA6 countries, the incomplete reversal of the fiscal stimulus implemented during the crisis has reduced fiscal buffers to confront possible future downturns (Celasun and others 15). Public debt in most of these countries remains above precrisis levels (Figure.11), primary balances have deteriorated, and, despite the still favorable global financial conditions, the difference between interest rates and GDP growth is larger than before. This heightens vulnerabilities to Figure.11 Deteriorated Fiscal Positions Countercyclical fiscal deficits have increased public debt in recent years. 1. LA5: Real GDP Growth and Structural Fiscal Balance Real GDP growth (percent) Structural fiscal balance (percent of GDP, right scale) LA6: General Government Gross Debt and Net Lending (Percent of fiscal year GDP) 8 6 Debt (change in 8 1) Debt, 8 Net lending, 15 (right scale) Peru Colombia Uruguay Chile Mexico Brazil Sources: IMF, World Economic Outlook database; and IMF staff calculations and projections. Note: For country acronyms see page Simple average of Brazil, Chile, Colombia, Mexico, and Peru. For definitions of government coverage, see Table.. potential shocks and spending pressures, including from long-term social liabilities, guarantees to public enterprises, and natural disasters, while at the same time tests the credibility and strength of existing policy frameworks. In view of these risks, there is a clear case for rebuilding fiscal buffers across LA6 countries. Gaining fiscal space is also needed to protect the income redistribution policies that have served LA6 countries well during the last decade (Box.). More specifically, in Brazil, the focus of macroeconomic policies should be on bolstering credibility and addressing supply-side constraints. Fiscal consolidation should proceed without

13 . OUTLOOK AND POLICY CHALLENGES FOR LATIN AMERICA AND THE CARIBBEAN delay and monetary policy should remain tight to bring inflation back toward the central bank s central target. Strengthening fiscal and monetary policy frameworks and alleviating structural bottlenecks are needed to boost investment, productivity, and competitiveness. Within this broad contour, exchange rate flexibility should continue to be used as the main external shock absorber. The ongoing foreign exchange intervention through swap operations could be gradually unwound and limited to episodes of excessive market volatility. Lending by public banks should focus on missing markets only; in practice implying reductions from their current level of credit creation. The risks to banks balance sheets from the effects of the recession calls for close supervision. In Mexico, monetary policy has remained appropriately accommodative as inflation is slightly below the central bank target and output below potential. The depreciation of the exchange rate reflects deteriorating oil prices (and their impact on future oil investment). With the monetary stance well calibrated to business cycle conditions, fiscal policy consolidation (consistent with a lower world oil price environment) is critical to put the debt ratio into a downward path. A steady and transparent implementation of the proposed structural reforms is critical. There is room for monetary policy to remain accommodative in Chile (given downside risks to economic activity and still well-anchored inflation expectations), while remaining attentive to second-round effects of the ongoing currency depreciation. Fiscal consolidation is warranted following this year s large fiscal impulse to help anchor inflation expectations and restore confidence. The structural reform agenda should be designed and implemented with the objective of minimizing potential short-term negative effects, including those related to policy uncertainty. Although the financial sector is generally healthy, prudential measures might need to be considered if corporate debt continues to grow rapidly. Strengthening the regulatory and supervisory framework for life insurance companies and financial conglomerates would buttress Chile s financial sector. Monetary policy faces similar challenges in Peru, where the economy has also been adjusting to the protracted decline in international metal prices. Allowing some pass-through of exchange rate depreciation to consumer prices is sensible, but monetary policy should remain responsive to inflation expectations and external developments. Exchange rate flexibility should be the first line of defense against any additional external pressures, although intervention may be needed to avoid excessive market volatility given dollarization. Ongoing dedollarization efforts should be continued, with macroprudential measures being a useful tool to strengthen the financial system while dedollarization proceeds. Deepening structural reforms to raise productivity and economic diversification would leverage the benefits of currency depreciations when shocks hit the commodity sector. Although Peru has policy space to do more if the slowdown is protracted, the priority should be effective implementation of existing stimulus measures. Accelerating the execution of public investment is urgent, while hikes in non-priority current spending should be avoided. As the recovery takes hold, the gradual withdrawal of fiscal stimulus will be appropriate. The Colombian economy is in an earlier phase of deceleration than the economies of Chile and Peru. Thus, so far, a broadly neutral monetary policy stance would be consistent with achieving the inflation target in the near to medium term, despite some near-term pressure on inflation from the currency depreciation. This said, inflation expectations need to be monitored carefully. Some fiscal tightening will be required to accommodate lower-than-expected revenues owing to weaker oil prices, however. Revenue mobilization will be needed to protect social and infrastructure spending, including through tax reform (increasing the rate and the base of the value-added tax) and better enforcement. Colombia s ambitious infrastructure program based on public-private partnerships is welcome, though contingent fiscal risks should be carefully assessed. With deepening 7

14 Parallel market exchange rate (Index: 1:Q1=1) REGIONAL ECONOMIC OUTLOOK: WESTERN HEMISPHERE financial activity in the country also comes the need for stronger supervision of nonbank financial intermediation, while the derivatives market s regulatory regime could be further simplified. In Uruguay, where inflation has exceeded the target range since 1, a comprehensive disinflation strategy is needed to bring inflation to the mid-point of the target range. This would include maintaining a tight monetary policy stance, moving toward more restrictive fiscal policy, and reducing the extent of backward-looking wage indexation. While exchange rate flexibility continues to be a key adjustment variable, it would be useful to strengthen risk weights for foreign currency loans to unhedged borrowers and to incorporate a greater exchange rate stress scenario into the supervisory stress tests. Other Commodity Exporters Developments and Outlook Weaker commodity prices have also affected most of the other commodity exporters of South America, which are less financially integrated (Figure.1). The abrupt drop in the price of oil since mid-1, on the one hand, has had a marked impact, especially in Venezuela but also in Bolivia and Ecuador. On the other hand, lower oil prices have benefited Paraguay, a heavy hydrocarbons importer. Venezuela has been pursuing unsustainable macroeconomic policies for several years on the back of widespread microeconomic distortions. This has resulted in high and rapidly increasing inflation (projected to be about percent in 15 and 16), a severe scarcity of goods, and a black market exchange rate that is currently more than 1 times larger than the lowest official exchange rate (in a system of multiple exchange rates, but for which 95 percent of the transactions take place at the lowest official exchange rate). Against this backdrop, Venezuela was hard hit by the sudden fall in its terms of trade (which has also compressed fiscal revenues from the governmentowned oil producer Petróleos de Venezuela Figure.1 Real GDP, Exchange Rates, and Sovereign Spreads Softer commodity prices strongly affected other commodity exporters. In turn, weaker terms of trade were amplified in countries with larger imbalances 1. Other Commodity Exporters: Real GDP Growth (15, percent) Bolivia Paraguay Argentina Ecuador. Parallel Market Exchange Rates 1:Q1 15:Q 1 Exchange rate gap 1,6 1, 1, 1, 8 6 Argentina :Q1 1:Q3 13:Q1 13:Q3 1:Q1 1:Q3 15:Q1 Venezuela 1, Venezuela 3. Other Commodity Exporters: Sovereign Credit Spreads 3 (Basis points) Argentina Paraguay 1, 1, 1, Inflation (end of quarter, yearover-year percent change), 3,5 3,,5, 1,5 1, Sources: Bloomberg, L.P.; Haver Analytics; IMF, World Economic Outlook database; national authorities; and IMF staff calculations. 1 Latest data for Venezuela are 1:Q. Difference of the parallel exchange rate and the official exchange rate as percentage of the official exchange rate. 3 Refers to J.P. Morgan Emerging Market Bond Index. 8 6 Bolivia Ecuador Venezuela (right scale) 5 8

15 . OUTLOOK AND POLICY CHALLENGES FOR LATIN AMERICA AND THE CARIBBEAN (PDVSA), private sector confidence has collapsed, and the economy has been in a deep recession since 1. Venezuela s GDP is projected to contract by about 1 percent in 15 and 6 percent in 16. Ecuador s economic and financial outlook has deteriorated substantially. Following a 3.8 percent expansion in economic activity during 1, GDP is projected to contract by about ½ percent in 15 and to remain flat in 16. This sharp deceleration results mainly from the strong fiscal response to the drop in oil prices, but also to the contraction of liquidity in the financial system and weakening consumer confidence. The oil shock and worse terms of trade in the presence of dollarization have caused a marked deterioration of the external current account, which has led the authorities to impose trade restrictions. In Argentina, a strong fiscal impulse has helped stabilize economic activity in 15 but macroeconomic imbalances have worsened. Government spending has boosted private consumption and construction activity, while industrial production growth ceased to decline in June and July (in year-over-year terms) after two years of contraction. Balance of payments pressures have remained relatively contained so far in 15, although the gap between the official and parallel exchange rates widened to about 5 percent as of September despite the central bank s attempts to increase the supply of foreign exchange and support the demand for the Argentine peso, including through higher deposit rates. The monetary and fiscal policy mix continues to be unsustainable, and macroeconomic imbalances, fueled by the greater monetization of fiscal deficits and exchange rate overvaluation, have deteriorated in 15. Growth is expected to remain around ½ percent for 15, with heavy foreign exchange controls continuing to depress investment and imports, while the weakening terms of trade, the ongoing recession in Brazil (Argentina s main trading partner), and the real appreciation of the peso weigh on exports and contribute to a further decline in the trade surplus. In Bolivia, owing to weaker hydrocarbon prices, growth is projected to moderate to a still-robust percent in 15, down from 5½ percent in 1. The external current account, which deteriorated from a surplus of 3½ percent of GDP in 13 to a balance in 1, is projected to further deteriorate to a large deficit of about ½ percent of GDP in 15. The slowing economy and weaker energy-related exports will further increase the public sector primary deficit in 15 to about 5 percent of GDP. Although Bolivia has some prior buffers, the sharp deterioration in the external current account and the fiscal balance are worth monitoring. In Paraguay, economic activity has slowed in recent months, reflecting adverse spillover effects from the recession in its largest trading partner, Brazil, and the continued decline in agricultural commodity prices. Nonetheless, the broader outlook remains comparatively benign, underpinned by sound macroeconomic fundamentals, favorable demographics, and the potential from ongoing economic diversification. Growth is projected to decline to 3 percent in 15. Policy Priorities First and foremost, greater exchange rate flexibility would allow these economies to better absorb the impact of weaker terms of trade (Figure.13). Countries with unsustainable fiscal expansions would need to go through the needed adjustment to put public finances in order. Venezuela needs to correct several years of macroeconomic and microeconomic mismanagement to turn around dire economic and social conditions. On the macroeconomic side, this includes reducing the public sector deficit and ending its monetization, reigning in extremely high inflation, and correcting the many distortions in the foreign exchange market. Removing trade restrictions and price controls is important to alleviate the scarcity of goods, while relative price corrections through the removal of subsidies and controls will be necessary to bolster confidence and stimulate private investment. 9

16 REGIONAL ECONOMIC OUTLOOK: WESTERN HEMISPHERE In Bolivia, a key policy imperative is to improve the nonhydrocarbons primary balance. A progressive approach to meet this objective could be pursued, particularly since there are currently sizable buffers of low debt, large reserves, low dollarization, and a reasonably sound financial system. Other important reforms include strengthening the monetary policy framework and upholding the central bank operational independence and the primacy of its price stability mandate; adopting a strong medium-term fiscal framework; clarifying commodity-related investment regimes; and improving the business climate in general. Modifying credit quotas and interest rate caps under the financial services law may be warranted if financial stability risks become material. Greater exchange rate flexibility would facilitate the adjustment to a new external context. Policy alternatives are more limited in fully dollarized economies, such as Ecuador. The authorities have adjusted to the new external conditions with a strong fiscal retrenchment, but any financing shortfall would have to be addressed with further fiscal effort. To regain competitiveness in the face of real currency overvaluation and prevent protracted slow growth, substantial real wage and price adjustments are called for. Diminishing liquidity in the banking system warrants close monitoring and rapid reaction if pressures continue, while eliminating restrictions and distortions in the banking system as well as enhancing supervision would make the system more resilient to shocks. The authorities own timeframe for removing import surcharges is an important policy decision, so that resource allocation responds more effectively to new market realities. Bolstering private sector confidence by improving the business environment would be key to stemming deposit declines and preserving dollarization, as well as to sustaining healthy medium-term growth and reducing oil dependence. A broad structural reform agenda will be essential to foster productivity, crowd-in the private sector, attract FDI, and raise economic diversification. Argentina needs to remove microeconomic distortions, which magnify the need for macroeconomic adjustment, in order to rekindle growth. In particular, foreign exchange controls have distorted relative prices, generated a parallel foreign exchange market, and eroded competitiveness. Utility prices have been frozen, driving a wedge between retail prices and cost recovery, while price agreements have temporarily contained deep inflationary pressures. Unwinding these distortions is crucial to a better allocation of resources and higher growth following price adjustments. Fiscal adjustment and a tighter monetary stance will be needed to contain the effects on inflation and limit the resulting depreciating pressures on the Argentine peso. In turn, eliminating distortionary subsidies and reducing inflation would pave the way for more equitable growth. In the case of Paraguay, sticking to the 1½ percent of GDP deficit target will be important to build credibility for the recently enacted Fiscal Responsibility Law. Efforts should concentrate on further improving tax enforcement and containing current spending. Meanwhile, structural reforms are critical to secure sustained solid growth the priority being to enhance the effectiveness of the public administration and provide better public 3

17 . OUTLOOK AND POLICY CHALLENGES FOR LATIN AMERICA AND THE CARIBBEAN services, including in infrastructure, education, and the legal system. Central America and the Dominican Republic Developments and Outlook Central America, Panama, and the Dominican Republic (CAPDR) have benefited from the recovery in the United States and the continued weakness in international energy prices, as the region is a net importer of hydrocarbons. This mix favors a virtuous circle of stronger demand, lower inflation, and a better external position. Yet, some of the hoped-for gains are still tentative, while strong policies are essential to reap durable benefits from the favorable conditions. Growth has been robust at ¼ percent over the year ending in the first quarter of 15 (Figure.1), but slightly below that of 1 (½ percent). Among the possible explanations for this small deceleration in economic activity is a cooling of remittances in the first half of 15. There have also been one-off country-specific drags to growth, including Intel s withdrawal from Costa Rica (particularly affecting its trade with the United States) and a deceleration of remittances to El Salvador. While the political crisis in Guatemala so far has not affected macroeconomic activity, the risks are tilted to the downside. On a positive note, Honduras output picked up in early 15, driven by investment and exports. Headline inflation in these countries has dropped well below their central banks targets, reflecting mainly the pass-through of lower commodity prices to domestic inflation (Figure.15). Core inflation has also been declining (except in Nicaragua). There were further modest policy rate reductions in inflation-targeting countries across the region. Going forward, output in the region is expected to grow at around percent in 15 16, broadly in line with its medium-term growth potential. With output gaps almost closed, inflation is expected to bounce back but to remain contained Figure.1 Growth and Remittances in CAPDR Trade traction with the United States seems modest so far and strong remittance flows have eased. Output growth is robust but not accelerating. 1. CAPDR: Goods Export Growth to the Untied States (Year-over-year percent change, 3-month moving average) Costa Rica CAPDR, excluding Costa Rica Mar-1 Jun-1 Sep-1 Dec-1 Mar-15 Jun-15. Remittances Growth (Year-over-year percent change, current U.S. dollars, 3-month moving average) Mar-13 May-13 El Salvador Guatemala, Honduras, Nicaragua U.S. Hispanic unemployment rate¹ (right scale) Jul-13 Sep-13 Nov-13 Jan-1 Mar-1 3. GDP Growth (Year-over-year percent change) May-1 13:Q1 13:Q3 1:Q1 1:Q3 15:Q1 Sources: Central American Monetary Council; national authorities; St. Louis Federal Reserve; U.S. Census Bureau; and IMF staff calculations. Note: Properly deflated corresponding volume data of trade with the United States are not available on a timely basis. The figure does not include services exports to the United States, which are important for some CAPDR countries. For country and region acronyms see page Three-month moving average percentage change. CAPDR = Central America, Panama, and the Dominican Republic. Jul-1 Sep-1 CRI, GTM, NIC, SLV DR, PAN CAPDR Nov-1 HND Jan-15 Mar-15 May